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  • October 11, 2013

    Mike Gitlin Mike Gitlin, head of T. Rowe Price's Fixed Income Division.

    A little more than five years ago, the U.S. economy and financial markets entered the country's worst financial crisis since the Great Depression. Mike Gitlin, head of T. Rowe Price's Fixed Income Division, discusses this historic period with Steve Norwitz.

    Norwitz:

    So Mike, after the collapse of Lehman Brothers in the fall of 2008, turmoil spread throughout the credit markets as liquidity dried up and yields on bonds, particularly noninvestment-grade bonds, really skyrocketed. But the markets did bottom in March of 2009, and since then bond markets have performed pretty well until recently.

    What drove the recovery in the credit markets over this period?

    Gitlin:

    Well, a few things drove that recovery, Steve. I think, first of all, the Federal Reserve and the U.S. Treasury did a very nice job of stopping the bleeding. We were in a state of panic at that point—the markets in general and the bank stress tests, the forced capital raises for the banks all caused some important calm in the markets as it related to the banking system.

    The government also had its alphabet soup of programs that helped—TARP (the Troubled Asset Relief Program) TLGP (the Temporary Loan Guarantee Program)—confidence we've had for the money markets, so a lot of the programs put in place helped stop the bleeding, which was first and foremost very, very important.

    The second thing that drove the recovery has been the accommodative stance of the Fed. The Fed has been incredibly accommodative since 2008, so just before the crisis started the Fed funds target rate was 5.25%. At the beginning of 2009 it was a 0- to 25-basis-points target rate, so the Fed had incredibly accommodative monetary policy that allowed the economy to start growing again and help the credit markets recover.

    Norwitz:

    Good. Well, the turnaround has been particularly impressive in the high yield bond market, where yields went from 20% at the peak around the time of the crisis down to a record low of around 5% that we saw this spring, and the default rate has also been historically low.

    What were the keys, in particular, for the high yield transformation?

    Gitlin:

    I think it's very important that what happened with high yield was we had a very elevated default rate, and that elevated default rate helped cleanse the market of some deals that occurred between 2005 and 2007 that probably shouldn't have occurred. They shouldn't have occurred. Those credits went bad. Default rates rose, and that cleansing of the market allowed the companies that survived to restructure their balance sheets and also have access to debt capital markets that were much lower cost of capital to them.

    So the survivorship bias, those that did survive, ended up surviving, restructuring, and benefiting from lower rates, and that ended up being very important for the rebound that we saw in high yield.

    Norwitz:

    And those companies today are in pretty good financial shape?

    Gitlin:

    They are. The companies are doing well. Default rates are very low, low single digits. The companies have had years and years of access to cheap capital, so they've been able to push out those theoretical walls of maturity by years, not quarters, and their underlying businesses are going quite well in general.

    Norwitz:

    So when we think back to the global financial crisis, there was a real fear that the financial system could collapse. Is the financial system, and the credit markets in particular, fully healed now, or are there lingering structural problems that still need to be resolved?

    Gitlin:

    Well, some things still need to be resolved. Some of the laws and regulations resulting from the crisis, like Dodd-Frank, the Volcker Rule, Basel III are still being negotiated. So there's some uncertainty remaining in the financial system in terms of what those final agreements will look like, and credit spreads haven't fully recovered. They've recovered, but they haven't fully recovered to pre-crisis levels.

    Those things being said, there's been a tremendous amount of deleveraging, so companies and individuals have deleveraged and look quite strong right now relative to the crisis period.

    Norwitz:

    So the system is on much sounder footing now than it's been any time in the last five years, I suppose?

    Gitlin:

    It certainly is. It has recovered. All-in yields are very, very low, so the risk-free rate is the main composition of why all-in yields are very low because, as I said, credit spreads haven't fully recovered to pre-crisis level, but all-in yields are because, as the Fed funds rate has stayed zero to 25 basis points, the risk-free rate remains still low.

    Norwitz:

    So were the unprecedented fiscal and monetary policies that were pursued by government authorities the right approach for the times? Did they prevent a global depression?

    Gitlin:

    I think people argue about the impact of the measures taken during the crisis, and my view would be the Federal Reserve and the Treasury did an exceptional job. I think we were on the cusp of a real global depression, and the actions of the Federal Reserve and the Treasury, while not perfect and will be viewed differently by people in hindsight, in aggregate those actions really stabilized the markets and gave confidence to the economy.

    Norwitz:

    Do you think that we have eliminated the risk of another financial crisis like the last one, at least for some time to come?

    Gitlin:

    I don't think in my professional career we'll see a crisis like the one we saw in 2008. I think that was very abnormal, and we won't see the same type of crisis. There will always be mini financial crises through cycles, but I think the magnitude of the one we had seen is something that's a once-in-a-professional-career event. Let's at least hope so.

    Norwitz:

    Well, that's very encouraging, because I should point out that you're still a young guy.

    Gitlin:

    Well, I appreciate that.

    Norwitz:

    What about the lessons learned? Are there any lessons that should be taken away from this experience by either individual or even professional investors like yourself?

    Gitlin:

    I think there are great lessons from the crisis for both individual and institutional investors. For individual investors I think there are two real lessons. One is stay balanced in your portfolio, don't get too heavily overweight in one particular asset class. And the second one is don't panic during a crisis. Unfortunately, there were a lot of individual investors who panicked during the end of 2008, beginning of 2009, which were the bottoms for both the equity and the debt markets, so not panicking during a crisis is a very good lesson. And the long-term ownership bias is a good lesson for individual investors.

    Norwitz:

    Well, certainly those investors who had a diversified portfolio at the time and held onto it have come out the other end in pretty good shape.

    Gitlin:

    They have. If you think about the S&P 500, for example, I think it bottomed around 666, and it's more than doubled since that period of time. And in 2008, high yield, for example, on a total return basis was down double digits and since then has had more than 10% annualized return over the last four or five years. So holding on during the period of crisis or buying even during the period of crisis turned out very well for individual investors.

    I think for institutional investors the biggest lesson to be learned is liquidity is critical because what we had was a real credit crisis but also a liquidity crisis. The broker-dealers who normally are the buyers of last resort in the marketplace were also deleveraging during the crisis.

    So if you look at the 21 primary dealers in the United States of America in aggregate they held 255 billion of corporate securities on their balance sheets before the crisis, and over the next 15 months they deleveraged and took that 255 billion down to 60 billion. So a group of traditional buyers at a point of weakness to provide liquidity to the market or the broker-dealers, they were some of the biggest competitors selling paper, so the lesson to all institutional investors was maintain an ample liquidity buffer, because during periods of crisis, liquidity is what will be most challenged.

    Norwitz:

    Well, that's a good segue into talking about whether or not there are any differences now in the way T. Rowe Price manages fixed income assets as a result of this crisis. Do you see any differences between how the firm manages fixed income assets now versus before the financial crisis struck?

    Gitlin:

    You know, we really haven't changed our stripes very much. In the crisis year of 2008 we had our best relative performance year in decades. So we tend to be a risk-aware fixed income manager, and during that period of time everyone had their absolute challenges, but our relative performance was quite strong, and so we remain a risk-aware investor.

    We take advantage of opportunities as we see them in the marketplace but always remind ourselves that our obligation is both capital preservation and income, not just one or the other.

    Norwitz:

    Looking at the environment today, what are some of the key risks that fixed income investors should be keeping in mind now?

    Gitlin:

    The two risks that fixed income investors normally worry about are interest rate risk and credit risk. For credit risk we think the overall risks in credit are quite low. Default rates are low single digits and are anticipated to remain that way for the foreseeable future, and companies are doing well and the economies globally are healing. So credit risk is always a concern for credit analysts, and we focus heavily on it, but those risks have come down quite a bit. On the interest rate risk side we've had a 33-year bull market in the risk-free rate in U.S. Treasuries, and I think the consensus view now is that rates will rise.

    There's a vigorous debate on how quickly rates will go up, but clients who have long-duration portfolios and long-duration strategies and institutional managers who manage long-duration money have to be cognizant of those interest rate risks and do their best that they can to hedge them to not have too much exposure.

    Norwitz:

    Do you think in general in this postcrisis environment that the so-called macro risks have become more important?

    Gitlin:

    It depends on what you're looking at. If you're looking at international or global equity strategies, they need to be more cognizant now of macro risks than probably at any other point. But if you look at something like a U.S. small-cap stock strategy, whether or not there are some challenges in emerging markets or some currency challenges in Brazil, that will be less impactful.

    So it really depends on what you were talking about. For fixed income investors we always are concerned about macro risks, and that hasn't declined at all, those concerns.

    Norwitz:

    So overall, what is your general outlook now for fixed income investing?

    Gitlin:

    Fixed income markets have performed exceptionally well since March of 2009. We fully acknowledge that the total returns in the next five years won't look like the returns we've had either in the past five years or 10 or 33 years. If you look at the Barclays [U.S.] Aggregate [Bond] Index, which represents U.S. core bonds, the annualized return since 1980 has been about 8.5%. That's exceptional. And so from 1980 to 2013 having an 8.5% return on the Barclays Agg., we believe the forward-looking returns are much more muted than that, potentially in the low to mid-single digits.

    So core bond management will be much more challenged in terms of the total returns we've seen in the past few decades. That being said, there are many opportunities still remaining in the fixed income markets. If you look at U.S. high yield you still get a 6.5% yield and against the backdrop of default rates that we think will be very low.

    If you look at bank loans, bank loans yield 5.5%. They're senior in the capital structure, and in the event of defaults, which we think will be quite low again, you end up with a 70% recovery rate on average.

    Municipal bonds are another opportunity. Because of the challenges we've seen in both Puerto Rico and Detroit, which have received a lot of press, there have been some outflows in the municipal bond markets, and that's taken yields to more attractive levels. You can buy a 30-year University of Virginia bond at 4% tax-exempt yield, or looking at the highest tax rate, 7% taxable equivalent for University of Virginia very highly rated bonds, so there's some opportunities left in the market.

    Emerging local would be the last one I'd mention, where emerging local currency bonds yield 6.5% and the average credit rating is investment grade, so U.S. high yield, bank loans, municipal bonds, emerging local currency debt all represent interesting yield opportunities even against a backdrop of the concerns of a rising rate environment.

    Norwitz:

    So looking ahead, returns are not likely to be, on average, as good as they've been in the recent past. But would you expect fixed income investors to at least earn the coupons?

    Gitlin:

    I think it depends on one's particular view on how fast rates will go up. If rates go up quicker than people think, the coupon will be offset by a negative return due to duration, and your total return may end up being zero. But if we think there will be a gentle rise in rates over a longer period of time, you'll have a positive total return in core bonds.

    Norwitz:

    Good. Well, Mike, thanks very much for sharing those insights as well as those reflections on the global financial crisis and the current market environment for fixed income investing. I appreciate it.

    Gitlin:

    Thanks, Steve.

    This interview is provided for informational purposes only and is not intended to reflect a current or past recommendation or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or a class of investor. Investors will need to consider their own circumstances before making an investment decision. The views are as of October 1, 2013, and may have changed since that time.

    Copyright 2014, T. Rowe Price Investment Services, Inc., Distributor. All rights reserved.